Personal Banking 101: Certificates of Deposit

For those who are interested in possibly earning more interest than can be had with many savings accounts, but still want the low degree of risk that comes with a deposit account insured by the FDIC, a certificate of deposit (CD) can be a reasonable choice.

What is a CD?

The Federal Reserve defines a certificate of deposit as a “time deposit.” This means that the money you put in the bank is held for a specific period of time. The understanding is that you will not withdraw the money before the maturity date. Because banks expect to have that money available to them for a specific period of time, they pay a higher rate of interest to you than they would on a savings account or an interest-bearing checking account. If you withdraw the money early, the financial institution will penalize you for it.

The Federal Reserve’s Regulation D insists that account withdrawals on time deposits made within six days after being deposited are subject to the loss of six days’ interest, but that is the only penalty required by the Fed. Many banks allow a “grace period” after the maturity date in which you can withdraw the money from the CD without penalty beyond the Fed’s required loss of interest. However, once you get beyond a “grace period” that a bank may have, you are subject to rather hefty early withdrawal fees.

CDs come in a variety of maturities. Most CDs can be found in maturities ranging from one month on up to seven years – or more. You can also get IRA CDs, marketed as ideal for retirement accounts. In many cases, longer terms can mean higher rates of return. CDs typically have minimums that range from $500 to $10,000. There are also jumbo CDs that deal in amounts in excess of $100,000. It is a good idea to do research on CD ladders are popular because they allow you to set up a system to access your money with more regularity, and because CD laddering also offers the chance to take advantage of rising interest rates. Because of the nature of CDs, once you put the money in, it is stuck there until maturity (unless you want to pay a hefty penalty) and you are stuck with the same interest rate. So, if interest rates rise two years after you lock into a five-year CD, you don’t get the advantage of those higher yields.

CD laddering helps you reduce the liquidity and yield issues presented by CDs. Instead of putting all of your money into one CD, you can divide it into five CDs. So, if you have $15,000 you divide it up into five CDs of $3,000, and then invest it in CDs of different maturities: one-year, two-year, three-year, four-year and five-year. This way, each year a CD matures. (There are also CD ladders that can be set up for months, rather than years.)

The beauty of the system is that once you get your ladder set up, you renew for five years. So, after the first year, you renew your expiring CD for five years, getting the higher yield for a longer-term CD that matures in year six of your ladder. You have access to the money if you should need it, and you can take advantage of interest rates that might be higher. Watch out for automatic renewal policies, though. Some banks will renew the CD for the same maturity, which could throw your ladder off. Find out if your bank practices this policy on your CD, and make sure you withdraw the funds at maturity and then open a new CD for the appropriate maturity.

Alternative CDs

Realize, too, that there are other, less “traditional” CD products. You can find them if you are looking for them. Here are some of the options you might run across:

• Penalty Free: A very few banks offer penalty free CDs that allow to withdraw funds before the end of the CD without penalty. The flexibility, though, usually means that you will have to settle for a lower yield.
• Bump Up: If these CDs see a rate increase for new depositors during the term, you have the option of increasing your yield.
• Callable: You can find higher rates if you get a callable CD. Basically this means that the bank can close your deposit account after a certain protection period has passed. So, you might open a seven-year CD with a one-year protection period. Any time after that year passes (and you might see a great yield for that year), the bank can close your account, forcing you to open a new CD – usually at a lower rate.
• Brokerage: Using a broker, you can look for CDs that can be traded on the secondary market. (Realize that not all brokerage CDs are FDIC insured.) If you need the money before maturity, instead of taking an early withdrawal penalty, you have to sell the CD on the secondary market, which could be for a loss.

Carefully consider your options, and then make a decision that makes the most sense for you. For many people, that is likely to be traditional CDs that are laddered.